Schumpeter and the Financial Instability Hypothesis 

"Economic progress, in capitalist society, means turmoil." ~ Joseph Alois Schumpeter

    While Schumpeter is most widely known for his contributions to economics through his theory of entrepreneurship, i.e., creative destruction, Schumpeter was much more than this whilst theorizing. Having multiple exceptional treatises on Economic History, Business Cycles, and Finance’s role in the real economy, Schumpeter’s economic tradition spanned multiple vibrant traditions that he does not get enough respect for. To Schumpeter, the economy was constantly in disequilibrating flux, constantly changing as all dynamic capitalist economics, making the use of equilibrium theory almost obsolete. Despite the few lapses in Walrasian General-Equilibrium theory for business cycle theories, Schumpeter remained true to this thesis of market economy dynamicity, a disequilibrating and explosive process that pushes the economy to more welfare-enhancing combinations through “Creative Destruction”; a conception that was in fact originally Marxist!1 Another tradition putting the dynamicity of the Capitalist economy at the forefront of its theory during a time of exceptional Physicist delusion was the Post-Keynesians, in particular, Hyman Minsky, the creator of the first formalized version of the Financial Instability Hypothesis. The FIH (Financial Instability Hypothesis) has recently gained increased traction since the 2008-2012 Economic recession, outlining the flaws of the mainstream Walrasians who were predicting times of exceptional progress and almost no possible recessions in the immediate future! This however, was demonstrated to be utterly deluded with the following financial crash in 2008 and the consequent shocks throughout the real sectors, pushing the economy in a recession that has not been seen in terms of severity since the original 1929-1939 Great Depression.

     The financial instability hypothesis brought something almost completely unknown to the Mainstream of economics since the 1930s, an endogenous theory of the business cycle. Hyman Minsky, defying the standard Walrasian conceptions of the business cycle, boldly claimed that the cause for instability was in fact stability, the paradox of tranquility! In times of stability, the economy’s particularly unstable financial sector undertook incredibly risky investments due to radical uncertainty and the illusion of forever economic progress, leading to investments that were incapable of being fully seen through and consequently forced liquidation. The original stable “hedge finance” units in an unregulated laissez faire economy turned into “Ponzi finance” units, unstable financial units consequently leading to unwise investments and forced partial or complete-liquidation when losses are finally realized. Only with proper regulatory oversight would the financial sector remain primarily composed of “hedge finance” units, rather than “Ponzi finance” units that characterize laissez faire economies during times of stability. 

Unfortunately Hyman Minsky’s theory of the business cycle is simply inadequate for a theory of the business cycle which encompasses the real sector, the financial instability hypothesis solely addressed the financial sector and presupposes a domino effect moving throughout the entire economy; decline of finance leading to decline of all other sectors. This theory however, cannot describe what exactly happens in a capitalist economy when this phenomenon of financial decline occurs, it cannot describe what factors are at work to lead to complete economic decline, why the entire economic system must collapse. However, a group of vibrant (primarily) German scholars have undertook a task of creating a new paradigm in economics, Neo-Schumpeterian Economics. 

    Neo-Schumpeterian economics (NSE) is a recently founded school of economics by economists such as Horst Hanusch seeking to revive Schumpeter’s theory of the dynamic market process and repurpose it for the entire economy, not simply a theory of entrepreneurship. These economists emphasize, similarly to the Post-Keynesians, radical uncertainty, and the endogenous nature of credit in the economy, as the Monetary-Circuitists in the Post-Keynesian tradition tend to do. Rather than being exogenously dropped from a helicopter as the New-Monetarists of the Mainstream tend to emphasize, credit & money in a modern capitalist economy is largely endogenous, and consequently leading to problems for standard policy measures advocated by the New and Neo’s of the mainstream along with multiple problems being posed with the standard loanable funds picture of the market economy, in which the mythical natural rate of interest equilibrates investment and savings. Endogenous money essentially reverses the causation between savings and investment, savings do not create investments, investments create savings through a conception of monetary circuits! Due to the fact this is a very complex topic, this topic will be left for another time to dive into the problems with exogenous money and the policy measures derived from endogenous monetary theories.

    The understanding of the Neo-Schumpeterians of the endogenous nature of money consequently leads to a much richer comprehension of money in the economy, it is not simply a deus ex machina created by market participants and is merely a veil, money and credit are created by private banks to finance entrepreneurial investments, which deliver themselves through the wage system and consequently deposits in private banks, a system of “circuits” in the modern market economy. For the Neo-Schumpeterians, the sole most important factor in the economy is the entrepreneur, as it is for the Post-Keynesians. The entrepreneurs in a market economy provide the crucial disequilibration functions that overthrow the previous disequilibrium regime to better satisfy consumers in the economy, through the process of seemingly paradoxical creative destruction the unemployment caused by the initial destruction is replenished by the creative aspect of creative destruction, increased employment and consequently increased consumption, a system of economic progress. The Neo-Schumpeterians compliment beautifully the Post-Keynesians in business cycle theories and Micro-MacroEconomics through providing an adequate theory of what proceeds to function in the real sectors of the economy through the boom. Looking at the boom, rather than simply ignoring it as the New-Classicals do and look directly towards the recession, the NS’s and the PK’s comprehend that the causal forces at work are always in the boom phase of the business cycle and consequently necessitates the need for an analysis of the boom during the business cycle. Taking from Schumpeter’s original business cycle theory, creative destruction, and even Hyman Minsky’s FIH (Financial Instability Hypothesis), Perez (2011) has developed a theory of the business cycle that adequately describes the working of modern capitalist economies. 

    Starting from the basic principle that business cycles are caused endogenously, as most Post-Keynesians and Neo-Schumpeterian Economists agree with, we may continue with the hypothesis of the business cycle theory. As has already been outlined, credit and money in an economy are largely endogenous rather than exogenous and dropped from a helicopter, meaning most money is created by private banks to finance entrepreneurial activity in the real sector. An often overlooked aspect of financial firms is that they do also engage in creative entrepreneurial activity, generally to loan money easier to credit worthy entrepreneurs, engaging in a similar sort of creative destruction in the economy. The only difference, however, is that financial creative destruction is quite distinct from creative destruction in a market economy’s real sector, financial creative destruction are often more disruptive than creative in such a fragile financial situation, in which those taking investment decisions in the financial sectors act as gamblers, even the slightest “destruction” could lead to increased economic fragility, soon collapsing due to the nature of the economy’s short and long run expectations, colloquially termed animal spirits. Financial creative destruction adds an important expansion to the standard Minsky-ian theory of the business cycle with sole “over-leveraging” and stability. Another route that can be taken to explain the real sector, can be taken with the same Schumpeterian principles, however. Investors in market economies often function similar to entrepreneurs in non-highly speculatory markets, always looking for profit opportunities and to satiate those they owe money to by managing to derive enough profits for both them and themselves. This consequently means there is a necessity for financial entrepreneurs to seek entrepreneurial opportunities.

     This can occur in multiple ways, the most common of which is following the recent innovations and the sectors in which creative destruction is much more prevalent, e.g., the software sector during the 1990s and Post the 2001 crash. The financial entrepreneurs often are looking to maximize the total amount of profits they can receive while maintaining less risky investments, however, in newly forming sectors that are subject to radical incalculable uncertainty, investment decisions are often subject to pure short-long run expectations rather than any basis in the past price systems. Crucial decisions, rendering the past-price system increasingly less valuable, which are often undertaken in sectors that are young and rapidly advancing further contribute to radical uncertainty. Considering the complete inability to base investment decisions from present and past prices as the Austrians seem to claim, the radical uncertainty and disequilibrium overtake said sector, e.g., a budding robotics sector. This consequently means that there are massive opportunities of immense profits for investors, but also opportunities of great loss due to the radically uncertain nature of said sectors. When entering these sectors, financiers tend to also attract a great deal of entrepreneurs in real sectors that wish to make profits. This feeds itself in a form of an investment multiplier, increased financers, increased entrepreneurs, and the circle continues to feed itself. What occurs then, happens to be a massive bubble in said sectors. To cope with the immense amount of funds being loaned out to a certain sector, an upwards pressure is put upon asset prices, continuing the bubble in the economy. The bubble in the real sector is constantly being fed upon itself, moving from the original positive boom in investment to an unstable and radically uncertain bubble in which financers and entrepreneurs feed one another through loans and returns. After a certain point, a clear phenomenon of not enough real resources existing to complete all projects occurs, along with a massive realization across the financiers that they are simply riding a bubble rather than a real economic increase in production. Realizing losses and the bubble sector, financers withdraw credit from that sector, leading to a collapse of that entire sector. This phenomenon is replicated across the entire economy that has budding sectors, along with collapses in sectors and firms which had contracts with these radically uncertain bubble markets, a phenomenon which works its way throughout the market economy, causing mayhem and a decline in investment expectations, necessitating the need for a revival in aggregate demand. To illustrate this phenomenon in a clearly understood example, let us demonstrate how this affects the economy with certain sectors: 

Let us suppose that economic actors in the economy, by being exceptionally productive with resources and satiating consumers in a radically new way, trigger the phenomena of creative destruction and immense technological progress in say, the robotics sector. The robotics sector consequently sees a massive increase in this production process’s profitability, a phenomenon that is incredibly attractive to prospective investors and financiers. This massive uptick in profits that were originally organic attract a great deal of financiers who act in an entrepreneurial manner to best satiate their own contractual arrangements, leading to creative destruction in the financial sector for the best way to provide loans and credit. The consequent phenomenon, as has been described above, is often much more destructive than creative due to the radically uncertain nature of the financial markets, and how malleable investment expectations are in a world of crucial decisions which render the past-price system a great deal more useless than before. Increasing the fragility of financial markets with the creative-destruction phenomenon, we may turn our eyes to the robotics sector, the sector that was originally in question. What occurs in that sector is an increase in prospective financiers who wish to act in an entrepreneurial manner to satiate their contractually bound arrangements and to provide for themselves.

    Entering this incredibly young and volatile robotics sector, however comes with multiple risks, e.g., Radical uncertainty which is fundamentally incalculable due the prevalent nature of Ontological Uncertainty in these sorts of investment decisions. Due to the prevalent nature of Ontological Uncertainty, investment in these sectors are incredibly uncertain and fragile. Despite the risks, prospective investors enter the market in order to satiate their profit motive, increasing the total amount of credit granted to the producers in the robotics market. This phenomenon leads to entrepreneurs in the real sector entering the markets in order to make a greater profit. The robotics sector, now, is forced to deal with an original organic phenomenon turning into a great bubble which feeds upon itself through investment multipliers due to the amount of prospective financial and real sector entrepreneurs entering this market. After a certain point, financiers are forced to confront the future, these investments were unsound and made based on radically uncertain conditions which turned out to be wrong, there were simply not enough real resources to complete these projects or carry through with loans. A massive decline in the economy consequently occurs, liquidation in the real sectors and financiers preventing themselves from loaning anytime in the near future due to pessimistic short and long run expectations, a situation that sets in as a recession. To make matters worse, are the future contracts in different sectors, e.g., a software sector that is interconnected with the robotics sector. With the now collapsed robotics sector, losses inflict themselves upon different sectors, and consequently, a multiplier effect finds itself across the entire economy due to the interconnected nature of the capitalist economy. With the increased financial instability due to the loan creative destruction and the bubbles in the real sector, what occurs is a complete decimation of the financial sector and at the same time the real sector. The entire economy is faced with immense turmoil, inability to recover without aggregate demand stimulation through fiscal policy to lead to a rebound in investment expectations and consequently investment demand & the employment effects that derive from the increase in production. 

The causal factor at the start of the bubble shares remarkable similarities with Minsky's theory of a transition from a “hedge finance” dominated financial sector to a “Ponzi finance” dominated sector. The Neo-Schumpeterian explanation provides the Minsky-ian FIH with a basis in the real sector, rather than the sole financial sector, completing the theory to make room for the entire economy without having to adopt the original equilibrium conditions that Schumpeter’s business cycle theory had adopted. Following from radical uncertainty and the consequences of stability in a laissez faire capitalist economy, the real sector also feels the consequences during the boom era, harming the entire economy due to the misdeeds of the financial sector.

References: 

1. Pettinger, T., & Langdon, M. (2018, January 22). Creative destruction. Economics Help. https://www.economicshelp.org/blog/20255/economics/creative-destruction/.